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A Theory of Conflicts of Interest in Banking Relationships

Wook Sohn

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Abstract

This paper highlights a dark side of banking relationships by elucidating the conditions under which a pre-existing relationship between a lending bank and a borrower can be detrimental to positive valuation effects of loan announcements. The effect of a pre-existing relationship is more likely to be negative when the pre-existing loans are large and firms screening costs are low. A theoretical model shows that loan announcements positive effect on borrowers value due to the standard information advantage can be more than offset by the banks conflict of interest when the banks asset quality reputation is poor, i.e., when the probability of the bank holding a bad loan is large.

Issue Date
2007
Publisher
Korea International Economic Association
Keywords
Conflicts of interest; Banking relationships; Soft-budget constraint; Sequential equilibriumJEL Classification: G21; G24; N221. IntroductionBank loan announcements provide additional information to equity markets about the quality of borrowing firms; Conflicts of interest; Banking relationships; Soft-budget constraint; Sequential equilibriumJEL Classification: G21; G24; N221. IntroductionBank loan announcements provide additional information to equity markets about the quality of borrowing firms
Citation
INTERNATIONAL ECONOMIC JOURNAL, v.21, no.2, pp.177 - 198, 2007
Journal Title
INTERNATIONAL ECONOMIC JOURNAL
Start Page
177
End Page
198
ISSN
1016-8737
Language
English
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